3 June 2009

What's wrong with the Treasuries models for Australian Growth

Steve Keen takes them to the woodshed, in detail.

Firstly, there is no discussion of what actually caused the GFC, here or anywhere else in Henry’s speech. The fact that it originated in the financial system is noted, but why it originated there, and what caused it, is not considered.

Secondly, “the long run” in the Budget papers is determined by assumptions the Treasury made about the economy’s future in its Intergenerational Report, which was published in 2007. Since those assumptions were made prior to the Global Financial Crisis, that means that the Treasury is assuming that the GFC will have no long term effect on the economy: it will suppress output and employment for a couple of years, but after that everything will return to how it was before the GFC came along.

Thirdly, the Treasury produced its Budget estimates for GDP growth by decomposing growth into 5 factors, making assumptions about those factors over time, and adding them up to produce estimates for 2010-2017. Four of the five numbers used–and the Treasury’s expectations for inflation as well–are shown below (the Treasury didn’t provide its estimates of average hours worked, so that factor is presumably collapsed into the employment rate; and their table [Table One on page 15] says “Unemployment Rate” where I believe they meant “Employment Rate”).

Note that Henry describes this decomposition as a “supply side decomposition”. There’s no argument that population is a “supply side” issue–not withstanding Peter Costello’s “Baby Bonus”, it’s fair to assume that the households decisions about whether to have children are not determined by economic conditions. Ditto productivity to some degree: higher economic growth should lead to higher productivity, but there will be productivity growth even when the economy is stagnant, so at a first pass one can treat productivity growth as independent of aggregate demand.

But are the participation rate and the employment rate “supply side” factors–set by household decisions alone rather than influenced by the demand that currently exists for workers? Henry also notes that all these factors “are cyclically sensitive”, which implies they are affected by demand conditions. So why call them “supply side” factors?

Because if you follow neoclassical economic theory, the rate of growth “in the long run” is determined by the labour supply decisions of households and the rate of productivity growth. While “in the short run”, neoclassical economists will concede that there can be insufficient aggregate demand to employ all workers who wish to work, in the long run they assume that everyone who wants a job can get one, so that “in the long run” the unemployment rate is determined by households, based on their preferences for income and leisure.

Credit issues–even ones as severe as the GFC–don’t factor into the Treasury’s modelling because, following neoclassical economics, they assume that money and credit don’t have any long term impact. Monetary factors like credit and debt are not included in Treasury’s macroeconomic model (TRYM) in any way. Ultimately, their model assumes that the economy will settle down to a long run equilibrium rate of growth determined solely by household labour supply decisions and the rate of technological progress.


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